Figure 24.1 (Macro 11) The Aggregate Demand Curve
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Between Inflation Interest Rate and Real GDP
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Showing Relation of
Interest Rate to
Investment
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STAGE I: Interest rate and Investment
• As real (inflation-adjusted) interest rate
goes up, cost of borrowing goes up, so that
business investment (buying a new machine
or extending business) and housing
investment declines.
• As real interest rate declines, investment
goes up, because the cost of investment
declines
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Showing Relation of
Interest Rate to Net
Exports
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Interest Rate and Net Exports
• If US interest rates increase, it becomes
more attractive to invest in the US,
compared to other countries such as Canada
or Mexico, our top trading partners.
• This raises the demand for US dollars and
appreciates the US dollar against other
currencies like Canadian $s or Mexican
pesos.
• This hurts our exports but raises our
imports.
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Interest Rate and Consumption Expenditures
• Evidence indicates that consumption is less
sensitive to interest rate changes than
investment and net exports
• In general, higher interest rates encourage
people to save more (consume less),
indicating an inverse relationship between
interest rates and consumption
• Figure 24.2 shows the net impact.
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Figure 24.2
(Macro 11)
The Interest Rate, Spending Balance, and Real GDP
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STAGE II: Interest Rates and Inflation
• So far we have seen how real interest rates
affect real GDP.
• Now we want to study how inflation affects
interest rates.
• Real interest rate = nominal interest rates
minus expected inflation rate
• Note that it is the real interest rate that we
use to decide about our spending plans
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